Impact of lower rates on insurance performance
Date: August 7, 2020
From: Guy Baker, PhD., MBA, MSFS
Re: Impact of lower rates on insurance performance
The insurance industry is going through an economic downturn due to low interest rates. This is impacting Capital Split Dollar which utilizes an indexed option strategy to earn credit rates. The loan from the bank is placed in the guaranteed General Account of the insurance company. The insurance company invests their assets and reserves to deliver interest earnings which are credited to the cash values of the policies they underwrite. As rates drop, the costs associated with the insurance increase as a percentage of the overall performance of the policy.
To offset the lower rate problem, insurance companies developed the indexed universal life chassis. Instead of crediting the interest rates to the cash value of the policy, the interest is used to purchase options on an index in different configurations. The cash values can be divided into segments and each segment is credited with a return based on the performance of the index during that time frame. The lower the rates, the fewer options the carrier can purchase.
An option usually collars the index. There is a floor and a cap. The floor for John’s policy is zero. The cap fluctuates with the interest rates. As of this memo, the cap is 8.5%. This means if the index returns more than 8.5%, the return credited to the policy will not exceed 8.5%. This cap is not guaranteed. If the index earns 5%, then the policy would be credited with 5%. If the index is negative, the return would be 0%.
In an effort to manage this process, we do two things. First, we diversify the cash values into 12 segments, one each month. We also select the best crediting option based on historical returns. To do this we use Monte Carlo analysis to gauge the probability of return. The index used in John’s policy is the S&P500 Index.
The S&P has been very volatile over the years. But 75% of the returns have been positive. The benefit of the floor is that the index does not have to recover from the steep downs.
The historical return for the S&P 500 over the last 93 years has been 10.4%. Since 2000, the return has been 5.4%, but since 2010, the return has been 12.89%. If you can take out the negatives, the results are much different. The 10-year S&P return since 2009 has been 14.4% if you remove the down markets. The question is, how has the IUL returns held up with declining caps?
Here we see a comparison of the S&P returns since 2009. Most commentators call the 2000-2009 period, the lost decade. But history tells us there is always a regression to the mean over long time frames. The S&P from 2009-2019 has an internal rate of return of 14.4%. As is the history of the S&P, there were 3 down periods. The other 7 years the market was up significantly. Using the zero-floor collar approach, with a 9.25% cap, the IRR is 7.33%. With an 8.5% Cap, the IRR is 6.75%. If the Caps were to decline to 8% and 7.5%, the respective returns of 6.35% and 5.96% are still higher than the illustrated rate in the client illustration.
The following charts show that from 2000-2019 – the poor showing of the S&P from 2000-2019 was offset by the IUL Caps and floor.
The Capital Split Dollar plan is a long-term strategy the relies on collared market returns along with the tax benefits inherent in an insurance policy.
The following table summarizes the cash surrender values at various interest assumptions. We believe the historic S&P data over the last 20 years demonstrates a 4% to 5% crediting assumption for the client policy is not consistent with the historic crediting rate when using the IUL collar methodolog
Example A – After 5 years of premium payments, the policy (assuming a 5% IRR for 11 years) has sufficient values to totally pay off the bank loan. There would be $189,613 of remaining cash values which could be redeemed through surrender or could be used to support a paidup policy on Lisa’s life of approximately $1.5 mil.
Example B – Using the same assumptions as Example A, but reducing the crediting rate to 4%, in the 11th year, the policy could only pay $2,535,380 of the outstanding loan of $2,925,000. The remainingdifference would be $389,620 and would be owed to the bank. John could retain or reduce the policy and begin paying premiums if that was a viable planning option.
Example C – The example shows that if the policy earns the current illustration rate (5.67%) there would be sufficient cash value to pay of the bank. The remaining cash value would be $675,880. By reducing the death benefit $3.4 million, the policy would sustain a significant death benefit with no additional premium (see schedule for illustrated death benefits).
Example D – The final example assumes that loan is NOT paid off in year 11 but in year 17 instead. After paying off the bank, there would remain $2,856,235 of cash value that could produce a tax-free income or could sustain a $6.479,000 death benefit for life. (See schedule for illustrated death benefits).
If you have any questions regarding this workup or the assumptions, we would be glad to provide further analysis or answers. Thank you for the opportunity to serve.
Dr. Guy Baker
BMI Consulting, LLC